Prof. Dr.

Pornchai Chunhachinda

International Parity Conditions

• Some fundamental questions of international financial
managers are:
- What are the determinants of exchange rates?
- Are changes in exchange rates predictable?
• The economic theories that link exchange rates, price
levels, and interest rates together are called international
parity conditions.
• These international parity conditions form the core of the
financial theory that is unique to international finance.
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 Prof. Dr. Pornchai Chunhachinda

1. The Law of One Price

• If the identical product or service can be sold in two

different markets, and no restrictions exist on the sale
or transportation costs of moving the product between
markets, the products price should be the same in both
markets.

• This is called the law of one price.

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 Prof. Dr. Pornchai Chunhachinda

• A primary principle of competitive markets is that

prices will equalize across markets if frictions
(transportation costs) do not exist.
• Comparing prices then, would require only a conversion
from one currency to the other:

P$ x S = P฿
• Where the product price in US dollars is (P$), and the
price in Baht is (P฿) the spot exchange rate is (S)
(Direct Quote).
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 Prof. Dr. Pornchai Chunhachinda

2. Absolute Purchasing Power Parity

• If the law of one price were true for all goods and
services, the purchasing power parity (PPP) states
that exchange rate could be found from any set of
prices.

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 Prof. Dr. Pornchai Chunhachinda

• By comparing the prices of identical set of products

denominated in different currencies, we could determine
the “real” or PPP exchange rate that should exist if
markets were efficient.
PI$ x S = PI฿
Where the prices of identical set of products in US
dollars is (PI$), the prices of identical set of products in
Baht is (PI฿) and the spot exchange rate is (S)
(Direct Quote).
• This is the absolute version of the PPP theory.
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 Prof. Dr. Pornchai Chunhachinda

3. Relative Purchasing Power Parity

• If the assumptions of the absolute version of the PPP

theory are relaxed a bit more, we observe what is
termed relative purchasing power parity (RPPP).

• RPPP holds that the relative change in prices between

two countries over a period of time determines the
change in the exchange rate over that period.

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 Prof. Dr. Pornchai Chunhachinda

• More specifically, if the spot exchange rate between

two countries starts in equilibrium, any change in the
differential rate of inflation between them tends to be
offset over the long run by an equal but opposite
change in the spot exchange rate.
S1 = 1+I฿
S0 1+I$

S1, S0 = Spot Exchange Rate (฿/ $) at time 1, 0

I฿ = Inflation Rate of Thailand
I$ = Inflation Rate of U.S.A.
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 Prof. Dr. Pornchai Chunhachinda

Purchasing Power Parity (PPP)

Percent change in the spot exchange
4 rate for foreign currency
P
3

-6 -5 -4 -3 -2 -1 1 2 3 4 5 6
-1 Percent difference in
expected rates of inflation
-2 (foreign relative to
home country)
-3

-4

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 Prof. Dr. Pornchai Chunhachinda

Empirical Test of PPP

• Empirical testing of PPP and the law of one price has
been done, but has not proved PPP to be accurate in
predicting future exchange rates.

• Two general conclusions can be made from these

tests:
- PPP holds up well over the very long run but poorly for
shorter time periods.
- The theory holds better for countries with relatively high
rates of inflation and underdeveloped capital markets.

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 Prof. Dr. Pornchai Chunhachinda

4. The Fisher Effect

• The Fisher Effect states that nominal interest rates in
each country are equal to the required real rate of
return plus compensation for expected inflation
• This equation reduces to (in approximate form):
i = (1+r)(1+ π)-1
= r + π + rπ
= r+π
Where i = nominal interest rate
r = real interest rate
π = expected inflation.

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 Prof. Dr. Pornchai Chunhachinda

• “Currencies with high rates of inflation should bear

higher interest rates than currencies with lower rates
of inflation.”
1+ πd = 1+id
1+ πf 1+if
• Empirical Tests of Fisher Effect
1. For short-term, the Fisher Effect holds.
2. For long-term, the Fisher Effect affected by
increased financial risks.
3. For private securities, the comparison are
influenced by unequal creditworthiness of the issuers.
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 Prof. Dr. Pornchai Chunhachinda

5. The International Fisher Effect

• The relationship between the percentage change in
the spot exchange rate over time and the differential
between comparable interest rates in different
national capital markets is known as the International
Fisher Effect.
• “Fisher-open”, as it is termed, states that the spot
exchange rate should change in an equal amount but
in the opposite direction to the difference in interest
rates between two countries.
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 Prof. Dr. Pornchai Chunhachinda

• More formally:
S 0 – S1 $ - i฿
S1 x 100 = i

• Where i$ and i฿ are the respective national interest rates

and S is the spot exchange rate using direct quotes (฿/$).

• Justification for the international Fisher effect is that

investors must be rewarded or penalized to offset the
expected change in exchange rates.
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 Prof. Dr. Pornchai Chunhachinda

• “Currencies with lower interest rates are expected to

appreciate relative to currencies with higher interest
rates.”
S1 = S0 1+i฿
1+i$
• Empirical Tests of International Fisher Effect
1. Lend some support to the International Fisher
Effect.
2. Indicate the long-run tendency for interest
differentials to offset exchange rate changes.
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 Prof. Dr. Pornchai Chunhachinda

6. Interest Rate Parity

• The theory of Interest Rate Parity (IRP) provides the
linkage between the foreign exchange markets and
the international money markets.

• The theory states: The difference in the national

interest rates for securities of similar risk and
maturity should be equal to, but opposite in sign to,
the forward rate discount or premium for the foreign
currency, except for transaction costs.
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 Prof. Dr. Pornchai Chunhachinda

• The forward rate is calculated for any specific

maturity by adjusting the current spot exchange rate
by the ratio of eurocurrency interest rates of the same
maturity for the two subject currencies.

F = 1+id
S 1+if

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 Prof. Dr. Pornchai Chunhachinda

• For example, the 90-day forward rate for the Swiss

franc/US dollar exchange rate (FSF/$90) is found by
multiplying the current spot rate (SSF/$) by the ratio of
the 90-day euro-Swiss franc deposit rate (iSF) over the
90-day eurodollar deposit rate (i$).

F = 1+id
S 1+if

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 Prof. Dr. Pornchai Chunhachinda

Interest Rate Parity (IRP)

i $ = 8.00 % per annum
(2.00 % per 90 days)
Start End
$1,000,000 x 1.02 $1,020,000
$1,019,993*
Dollar money market

S = SF 1.4800/$ 90 days F90 = SF 1.4655/$

Swiss franc money market

SF 1,480,000 x 1.01 SF 1,494,800

i SF = 4.00 % per annum

(1.00 % per 90 days)

• Note that the Swiss franc investment yields $1,019,993, $7 less on a $1 million investment.
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 Prof. Dr. Pornchai Chunhachinda

• The forward premium or discount is the percentage

difference between the spot and forward exchange
rate, stated in annual percentage terms.

f SF = Spot – Forward 360

x x 100
Forward days

• This is the case when currency SF/$ is used.

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 Prof. Dr. Pornchai Chunhachinda

Currency Yield Curves & The Forward Premium

Interest
yield Eurodollar
10.0 % yield curve
9.0 %
8.0 %
7.0 %
Forward premium is the
6.0 % percentage difference of 3.96%
5.0 % Euro Swiss franc
4.0 % yield curve

3.0 %
2.0 %
1.0 %
Days Forward
30 60 90 120 150 180

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 Prof. Dr. Pornchai Chunhachinda

7. Covered Interest Arbitrage

• The spot and forward exchange rates are not,
however, constantly in the state of equilibrium
described by interest rate parity.
• When the market is not in equilibrium, the
potential for “risk-less” or arbitrage profit exists.
• The arbitrager will exploit the imbalance by
investing in whichever currency offers the higher
return on a covered basis.
• This is known as covered interest arbitrage (CIA).
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 Prof. Dr. Pornchai Chunhachinda

Covered Interest Arbitrage (CIA)

Eurodollar rate = 8.00 % per annum

Start End
$1,000,000 x 1.04 $1,040,000 Arbitrage
$1,044,638 Potential
Dollar money market

S = ¥ 106.00/$ 180 days F180 = ¥ 103.50/$

Yen money market

¥ 106,000,000 x 1.02 ¥ 108,120,000

Euroyen rate = 4.00 % per annum

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 Prof. Dr. Pornchai Chunhachinda

• The following exhibit illustrates the conditions

necessary for equilibrium between interest rates and
exchange rates.
• The disequilibrium situation, denoted by point
U, is located off the interest rate parity line.
• However, the situation represented by point U is
unstable because all investors have an incentive to
execute the same covered interest arbitrage, which is
virtually risk-free.
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 Prof. Dr. Pornchai Chunhachinda

Interest Rates Parity (IRP) and Equilibrium

4

2
Percentage premium on
foreign currency (¥)
1
4.83

-6 -5 -4 -3 -2 -1 1 2 3 4 5 6
-1

-2

-3

Percent difference between foreign (¥) -4 X U

and domestic ($) interest rates
Y
Z 24
 Prof. Dr. Pornchai Chunhachinda

8. Forward Rate as an Unbiased Predictor

for Future Spot Rate
• Some forecasters believe that forward exchange rates
are unbiased predictors of future spot exchange rates.

• Intuitively this means that the distribution of possible

actual spot rates in the future is centered on the
forward rate.

• Unbiased prediction simply means that the forward

rate will, on average, overestimate and underestimate
the actual future spot rate in equal frequency and degree.
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 Prof. Dr. Pornchai Chunhachinda

Forward Rate as an Unbiased Predictor for

Exchange rate Future Spot Rate
t1 t2 t3 t4

S2 F2

S1 Error F3
Error

Error
F1 S3

S4

Time
t1 t2 t3 t4
The forward rate available today (Ft,t+1), time t, for delivery at future time t+1, is used as a “predictor” of the
spot rate that will exist at that day in the future. Therefore, the forecast spot rate for time St2 is F1; the actual spot
rate turns out to be S2. The vertical distance between the prediction and the actual spot rate is the forecast error.
When the forward rate is termed an “unbiased predictor of the future spot rate,” it means that the forward rate
over or underestimates the future spot rate with relatively equal frequency and amount. It therefore “misses the
mark” in a regular and orderly manner. The sum of the errors equals zero.
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 Prof. Dr. Pornchai Chunhachinda

9. International Parity Conditions in Equilibrium

(Approximate Form)
Forward rate Forecast change in Purchasing
as an unbiased spot exchange rate power
predictor +4% parity
(yen strengthens)
(E) (A)

Forward premium International Forecast difference

on foreign currency Fisher Effect in rates of inflation
+4% -4%
(C) (less in Japan)
(yen strengthens)

Interest Difference in nominal Fisher

rate interest rates effect
parity -4% (B)
(D) (less in Japan)
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